Misconstruing Germany Will Prove to Be Death of the Euro

When I go from one European capital
to another, talking to officials and senior politicians about
the future of the euro, Germany feels less like another country
than a different planet.

In Madrid and Dublin, a euro-area banking union -- the
prerequisite for bailing out banks directly -- is discussed as
if it were a foregone conclusion. Both Spain and Ireland are
hoping their governments ultimately won’t have to finance the
rescue of their banks alone.

Top officials in Germany work on the assumption that a
meaningful banking union will never happen.

I recently spoke, for example, on a panel about the
proposed banking union at a conference in London that was hosted
and attended by senior German businessmen, politicians and
Finance Ministry staff. After my introduction, one senior
official explained the German position on a banking union in
just five words: “We do not want it.” I looked around to see a
sea of heads nodding in agreement.

This cognitive dissonance within the euro area is
potentially fatal, leading to misinterpretation of the
intentions of the currency bloc’s indispensable nation: Germany.

Rowing Back

Take the last European Union summit, in October. EU summits
are ritualized events at which member states’ national leaders
sign joint statements and then rush off to their assigned rooms
in the building to hold separate news conferences. There, they
try to define what the deal really means. German Chancellor
Angela Merkel signed the October summit’s conclusions, which
committed to start building parts of a banking union, and then
started to distance herself from it before she had left the
building.

This raised a few eyebrows, but it should have raised the
alarm. Most commentators assumed that any backtracking was just
about election schedules. Merkel was keen to push off
potentially contentious issues until after Germany’s 2013
elections, they argued.

That assumption was probably false. Germany isn’t
interested in taking the steps required to establish an
effective banking union, not now and not ever. Without a banking
union -- and, by extension, some degree of fiscal union -- the
euro project stands little chance of survival.

To explain why, you have to go back to the start of the
crisis. By 2007, euro-area bank balance sheets ballooned so much
that the total assets of the banking system reached more than
300 percent of gross domestic product, compared with less than
100 percent of GDP for banks in the U.S. Given the
interconnectedness of Europe’s financial institutions, it was
feared that the failure of one lender might bring down the
entire system. So a decision was made to avoid the insolvency of
any major bank in the euro area at all costs.

As banks were recapitalized by their governments, a
negative-feedback loop developed between lenders and their
sovereigns. In some countries, states stepped in to prop up
their ailing banks, while in others the banks stepped in to prop
up their ailing sovereigns.

Bottomless Pit

This was most obvious in Ireland and Greece. The bottomless
pit that was the Irish banking system sank the state, as bank
debt was foisted onto the Irish sovereign’s balance sheet. In
Greece, banks were hit hard, first by deposit flight as savers
worried that the country might leave the euro, and then by a
hefty “haircut” -- or writedown in value -- imposed on
privately owned Greek government bonds, with which Greek banks
were stuffed to the gills.

The main objective of a banking union is to break this
negative-feedback loop by allowing banks to fail and to be
liquidated or recapitalized without contagion to other lenders
or to sovereigns. In order to work, the union has two minimum
requirements.

The first is a single supervisory mechanism to oversee all
banks in the euro area. The second is a bank-resolution plan,
which would put processes in place for recapitalizing
systemically important banks that get into difficulty, and for
liquidating their nonsystemically important counterparts.

Some progress has been made on establishing a supervisory
mechanism. At the EU summit in October, euro-area policy makers
agreed to legislate one by the end of 2012, and to implement it
in 2013. Once this has been done, policy makers agreed that the
EU bailout fund, the European Stability Mechanism, will be able
to recapitalize banks directly.

Germany only wants the mechanism to supervise systemically
important banks. It’s no secret that this is because Merkel
doesn’t want euro-area supervisors poking around Germany’s sick
Landesbanks and highlighting that Germany’s banking system
hasn’t been immune to the crisis. This hurdle is probably
surmountable.

The bank-resolution plan is a much bigger stumbling block,
because to be able to recapitalize one or more systemically
important banks in the euro area, a body with very deep pockets
would have to be established. The money in those pockets would,
of course, be mainly German.

The euro area already has money in its bailout funds, but
that 500 billion euros would probably be too little to
recapitalize Europe’s biggest banks. The only way to amass the
financial firepower needed is to pool tax revenue. A banking-
resolution plan therefore involves some form of fiscal union.

Digging In

This is where German heels dig in. Merkel has demonstrated
over the past few years that she won’t be pushed into a fiscal
union as a short-term response to a crisis. She sees this union
as the culmination of a very deliberate, long-term process that
first involves countries signing up to fiscal checks and
balances and establishing a credible track record of sticking to
fiscal targets.

Only if those hoops have been jumped through will Germany
consider pooling assets across the euro area and, later still,
mutualizing debt. Setting up an effective banking union now
would require Germany to skip those first steps.

Even if Germany were willing to sign up to pooled assets
and joint tax collection, the old U.S. adage “no taxation
without representation” applies in Europe, too. A body that
could raise taxes across the euro area would have to be firmly
embedded within a democratically elected institution at the
European level. This would involve a huge transfer of
sovereignty from the Bundestag -- Germany’s parliament -- and
the German Finance Ministry to the European level, for which
there is zero appetite in the German ministries.

If Germany doesn’t change its position, the best we can
realistically hope for is that it will continue to pay lip
service to eventually establishing an effective banking union,
and that the European Central Bank will pretend to believe this
fiction in order to continue buying euro-area sovereign bonds.
That could keep the wheels on the euro-area project for some
time. But it cannot solve the crisis.

(Megan Greene is the director of European economics at
Roubini Global Economics. Read more from Greene at
www.economistmeg.com. The opinions expressed are her own.)